Financial products can be extremely complex. Investors aren’t happy with simple stocks, mutual funds or even ETFs. Securities have to be combined, derived, collateralized, tranchensized (okay, I made that last one up). If bonds weren’t hard enough for many people to grasp – prices and rates move inversely – other securities like the mortgage on your house or a company’s manufacturing plant are turned into tranches and sold as first-mortgage bonds. Sometimes several tranches will existing, each tranche containing a different level of risk. Let me explain.
Bonds in their simplest form are debt instruments. When a large company needs to borrow money, a bank is usually not the best and most efficient choice. Instead they issue bonds to the public and in turn, the bond holders receive an interest payment for the money he/she has loaned to ABC, Inc. Commonly, bonds are issued in increments of $1,000 and the total issue is often billions or at least millions.
Furthermore, bonds can either be collateralized or non-collateralized. In this way they’re similar to personal loans. For example, your car loan is collateralized – if you don’t make your monthly payment, the bank reposes the car since that was collateral for the loan. When an asset is involved, the interest rate that you pay will be lower. On the other hand, a revolving credit card balance is not backed up by any assets. For this increased level of risk, the credit card company will charge a higher interest rate to account for the heightened risk. If you default and claim bankruptcy, they will collect nothing from you.
Back to first-mortgage bonds. Again, these bonds are secured by the property that the issuer owns. The bank that issued your mortgage may package the loans or a corporation will do the same with the property they own. These loans are considered very secure because they company is depending on these assets to survive. Without the land and the plant that sits on the land, products cannot be manufactured.
Debt Must Make Sense
When issuing debt, companies must also justify their reasons for doing so. If publicly traded, this case has to be made to shareholders and if private, the board must be convinced. The same can be said in your personal life. Why borrow money when your purchase cannot be rationalized? You want to borrow $100,000 from the bank to fund the research on the time machine prototype in your basement? I don’t think so. Oh, you want to borrow $100,000 at 5% to buy machinery that will lower your cost of goods sold and increase your profit margin by 10%? That makes a little more sense.